On Our Radar

On Our Radar

Audit Techniques for Hobby Losses

“Activities not Engaged in for Profit” or, in layman’s terms, hobbies, tend to be a red flag at the IRS.

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Many taxpayers have hobbies that earn a bit of income and the IRS states that in such cases, expenses can be written off only to the extent of sales. A break-even proposition at best. So if you love photography and your buddy pays you $500 to shoot his wedding, you can write off all of your expenses up to $500 against that taxable income. But you cannot dip to the negative side and show a loss.

Many small business owners--particularly in this economic climate—are trying to shift their hobby into a bona fide business venture. And if it really is a business venture, then you are allowed to write off expenses in excess of sales and enjoy a loss against other income on your tax return thus reducing your tax liability. The trouble is, you’ve got to prove it.

So let’s say for the last three years you’ve been trying to make a go of your photography career. You’ve purchased state-of-the-art equipment and supplies, got a business license and worked to build a client base, but so far, you’ve only shown losses. And here comes the IRS looking to perform an audit of your business. But what’s in the back of the auditor’s mind is reclassifying your endeavor as a hobby. The losses will go away not just for the year under audit but for any other open years as well. And bam! You will owe the IRS a nice piece of change.

However, just because you are showing losses in a career that’s more fun than work, does not mean that your business is a hobby. The IRS must prove lack of business intent or have proof that the activity is not being treated as a business.

Prior to the audit, the examiner will look at your tax return. Here are some items that may indicate a hobby rather than business venture:

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Large expenses but very little in the way of sales reported on your Schedule C

How the loss impacts the return – is it offsetting other income and substantially reducing your tax liability?

During the first phase of the audit, the examiner will pose various questions, and your answers could hint at a hobby rather than a business venture. Agents will want to speak to the taxpayer directly, but you have the right to representation and are not required to be present or answer any direct questions from an auditor.

Make sure your tax pro is informed of your daily business operations, the history of your business, how your books and records are maintained, your marketing strategies, your educational background and the content of your business plan. If the tax professional doesn’t have adequate knowledge in these areas, the auditor has the right to issue a summons to require the presence of the taxpayer. The examiner will also want to visit your business to get an overview of your operation.

An agent will also perform a “Tax Savings Benefit Analysis,” in which the reported income tax liability will be compared to what the liability would be without the business losses, and then check to see if the business appears to be on a trend toward profitability.

The IRS Audit Techniques manual lists nine factors the auditor will invoke to make the determination of “Whether or not an activity is presumed to be operated for profit requires an analysis of the facts and circumstances of each case. Deciding whether a taxpayer operates an activity with an actual and honest profit motive typically involves applying the nine non-exclusive factors contained in Treas. Reg. § 1.183-2(b). Those factors are:

The manner in which the taxpayer carried on the activity,

The expertise of the taxpayer or his or her advisers,

The time and effort expended by the taxpayer in carrying on the activity,

The expectation that the assets used in the activity may appreciate in value,

The success of the taxpayer in carrying on other similar or dissimilar activities,

The taxpayer’s history of income or loss with respect to the activity,

The amount of occasional profits, if any, which are earned,

The financial status of the taxpayer, and

Elements of personal pleasure or recreation. “

These audits can be very tricky to handle and tax professionals can make the process more efficient and beneficial for small business owners. If you feel you can handle the audit yourself remember that if you don’t like the way things are going, or if you don’t understand something, you have the right to halt the audit and seek out help from a tax pro.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitterat BLTaxpertise and at Facebook.